August 17, 1930 was a Sunday with no Journal, so again a little editorial commentary.
Today I'm going to do something a bit off-topic, but I think important and not totally irrelevant. Lest we forget, there was a guy named Bernie Madoff who was involved in a huge financial scandal that came to light late last year that also revealed an incomprehensible failure of regulation by the SEC. Revelations of such scandals are in fact pretty characteristic of severe busts (as Buffett put it, you don't see who's been swimming naked until the tide goes out). A disturbingly high proportion of my friends seem to have some misconceptions about the Madoff affair, so I thought a little editorializing was in order. I'm not sure how much impact my own blathering would make, but fortunately there is a great resource for informing yourself on the scandal available here. This is a link to the video and transcribed Congressional testimony of the guy who probably knows more about the whole affair than anyone, and spent about 10 years trying to get the SEC to do their job: Harry Markopolos. If you have a few spare hours I would highly recommend watching the whole thing - for those with strong stomachs, I'd even recommend the nauseating performance of the regulators that follows HM's testimony. However, for those of you who don't have the time, I'm including some informative excerpts here.
[Opening statement - full cost of the SEC's failure.]
First, I would like to extend my deepest sympathy to the many thousands of victims of this scheme. We know that many victims have lost their retirement savings and are too old to start over. We also know that others have lost medical services, community services, and scholarships provided by charities that were wiped out by the Madoff fraud. This pains me greatly and I will do my best to inform you, the victims, about my repeated and detailed warnings to the SEC. You, above all others, deserve to know the truth about this Agency’s failings, and I will do my best to explain them to you today. ...
As today’s testimony will reveal, my team and I tried our best to get the SEC to investigate and shut down the Madoff Ponzi scheme with repeated and credible warnings to the SEC that started in May 2000 when the Madoff Ponzi scheme was only a $3- to $7 billion fraud. We knew then that we had provided enough red flags and mathematical proofs to the SEC for them where they should have been able to shut him down right then and there at under $7 billion. ... In October 2001, when Madoff was still in a $12- to $20 billion range, again we felt confident that we had provided even more evidence to the SEC such that he should have been stopped at well under $20 billion. And again in November 2005, when Mr. Madoff was at $30 billion, 29 red flags were handed to the SEC. And yet again, they failed to properly investigate and shut down Mr. Madoff’s operation.
Unfortunately, as they didn’t respond to my written submissions in 2000, 2001, 2005, 2007, and 2008, here we are today. A fraud that should have been stopped at under $7 billion in 2000 has now grown to $50 billion. I know that you want to know why there was over $40 billion in additional damages, and I hope to be able to provide some of those answers to you today.
[Were individual investors who lost money to Madoff greedy and stupid?]
Mr. ACKERMAN. ... The final question, I represent a large number of people who invested with Mr. Madoff ... The question that we get asked, all of us all the time, is, why didn’t people do due diligence? ... Could anybody have figured it out?
Mr. MARKOPOLOS. If you did not have a derivatives and quantitative finance background, it would have been very difficult to figure this out on your own as an individual investor.
Mr. ACKERMAN. The people who are blaming the victims for being stupid and not doing due diligence are off the mark?
Mr. MARKOPOLOS. A lot of the victims thought they were getting highly diversified portfolios. This is the beauty of Mr. Madoff’s scheme. He was purporting to own 30 to 35 of the bluest chip stocks, the largest companies in America, and they would see that on their statement, and they felt very comfortable owning those companies and they considered it a very diversified basket because it really was a very diversified basket.
Mr. ACKERMAN. But there was nothing they could do to check it out, that he didn’t actually buy it.
Mr. MARKOPOLOS. ... As an individual investor, you could not. But as a feeder fund, you should have been able to go to the New York Stock Exchange and see that those volumes of stock did not trade on that day at that price. They could have gone to the option price reporting authority that the Chicago Board Options Exchange offers, and you would have seen that no OEX index options traded at those prices that day. That is what you could have done and no one did that.
Mr. ACKERMAN. And the SEC could have done that, too?
Mr. MARKOPOLOS. If they knew how to do it, they could have done it. And if they had the willingness to do it, they could have done it. But they did not.
Mr. ACKERMAN. Thank you very much.
Chairman KANJORSKI. If they knew how to do it. Are you suggesting they do not know to do that?
Mr. MARKOPOLOS. I am suggesting that if you flew the entire SEC staff to Boston and sat them in Fenway Park for an afternoon, that they would not be able to find first base.
[Can the market regulate itself?]
Mr. ARCURI. ... Does the market itself, do they look at, you know, competitors who are out there, who are doing jobs that are too good to be true and say, hey, something must be wrong here; somebody needs to look into this?
Mr. MARKOPOLOS. Well, I am afraid not. They missed subprime. They missed the collateralized debt obligations, the collateralized loan obligations. They missed so much it is hard to just trust in the professionals. You need competent regulators as well, and you also need common sense.
Mr. ARCURI. My concern is this, if I am an investor and I am looking at the two prospective groups to invest my money in and one is doing everything legally and they are giving, let’s say, 5 or 6 percent, and then you are looking at a Madoff who is giving a return of, say, 10 or 12 percent, the person who is giving the 5 or 6 percent has to be looking at Madoff and saying, something has to be wrong here, someone needs to look at that. Isn’t there more pressure from the actual private sector itself to look into these?
Mr. MARKOPOLOS. I am afraid the private sector would look at the Madoff returns and say, he is getting more return, taking less units of risk, therefore I love Mr. Madoff better and I want to invest with him more. So greed often overrules common sense.
[Needed changes in the SEC and in regulation.]
The incoming SEC Chairwoman needs to come in and clean house with a wide broom. The SEC needs new senior staff because the current staff has led our Nation’s financial system to the brink of collapse. They ignored the rating agency scandals. They allowed the investment banks to engage and package and sell toxic subprime securities to investors. They ignored auction-rate securities and allowed these toxic securities to be sold to investors. They ignored mutual fund market timing until embarrassed by State regulators into acting, and they ignored the Madoff Ponzi scheme. They haven’t earned their paychecks and they need to be replaced. ...
I would urge the Congress to consider the fine examples set by the New York attorney general’s office and the Massachusetts Securities Division. They give great regulation on the big cases that are nationwide fraud cases, and they get full restitution to the victims. They are aggressive. But they are small. They don’t do a lot of examinations. All they do is take in whistleblower tips and act upon them and act vigorously. They are pit bulls against financial fraudsters. And here we have a pip-squeak of a flea in the SEC. So it is not the size of the dog, it is the size of the fight in the dog. And that is why I commend those two State regulators. They are very aggressive.
And if the SEC does not reform itself, you have an option. Just disband the SEC, zero out their budget, put all 3,500 of those people on the streets, because they are not protecting us right now; and just fund the New York attorney general’s office and the Massachusetts Securities Division. ...
Mr. CAPUANO. ... I would argue that some of those things may require us to have a little bit more complicated regulatory scheme. Is that something you have considered or not?
Mr. MARKOPOLOS. I wouldn’t say more complicated. I would say more simplified, more streamlined because remember, American business wants as few regulators as possible. They are paying for the regulation. They want a value-added proposition. For every dollar they spend toward regulation, they want to receive that value back because right now without proper regulation, there is no trust in our capital markets, which raises the cost of capital or makes it unavailable to American businesses. ...
Mrs. BIGGERT. ... should we be looking at the regulations and the laws on the books and trying to decide whether they are adequate enough to address this issue, or is this more a failure, really, of enforcement? ...
Mr. MARKOPOLOS. It is both, Congresswoman. It is, we need a few more regulations; we can leave no more dark spots unregulated and unguarded for financial predators to congregate in. ... And the second part is, we need better people in the enforcement agencies. They really need to replace a lot of their staffs, especially at the senior levels.
+ The Boring Stuff:
[Summary of SEC's recent effectiveness.]
The SEC says it lives for the big cases, but the evidence shows that the only financial regulators bringing the big cases in the 21st Century are the New York Attorney General’s Office and the Massachusetts Security Division. New York and Massachusetts brought the big cases against the market timing scandals and the auction rates securities scandals, while the SEC watched quietly from the sidelines. Even today after Merrill Lynch paid out $6 billion in bonuses after losing untold tens of billions of dollars and is being propped up by government bailout money, only the New York Attorney General is investigating. The SEC continues to roar like a mouse and bite like a flea.
... We have also heard senior SEC officials bemoan the lack of both staff and resources while telling us that they receive thousands of tips each year and that they have to conduct triage and can only respond to the highest priority matters. I gift-wrapped and delivered the largest Ponzi scheme in history to them, and somehow they couldn’t be bothered to conduct a thorough and proper investigation because they were too busy on matters of higher priority. If a $50 billion Ponzi scheme doesn’t make the SEC’s priority list, then I want to know who sets their priorities. ...
The American public deserves answers from the SEC about its refusal to tackle the big cases and why all five major Wall Street investment banks under SEC supervision either failed, were forced by the government to merge with commercial banks, or became bank holding companies propped up by the Federal Reserve and the U.S. Treasury. When an entire industry that you were supposed to be regulating disappears due to unregulated unchecked greed, then you are both a captive regulator and a failed regulator. You have no excuses. But you darn well have a lot of explaining to do to the American taxpayers and you darn well better be apologizing to the Madoff victims.
Mr. SHERMAN. ... Did you have a chance to bring your accusations to FINRA or the NASD?
Mr. MARKOPOLOS. I would have never taken them to the NASD or FINRA. I had a lot of bad experiences as an over-the-counter trader in the late 1980’s with the NASD. What I found them to be was a very corrupt, self-regulatory organization, that if you took a fraud to them, they would ignore it as soon as they received it. They were there to assist industry by avoiding stricter regulation from the SEC. ...
Mr. CASTLE. ... Do you put FINRA and the NASD in the same camp of being ineffective because they are basically part of the entity that Madoff and others have come from? Or do you separate the two of them?
Mr. MARKOPOLOS. I would separate them. I would say that the FINRA is even less competent than the SEC. And I never thought that the SEC was corrupt. In fact, I am living proof here today that they are not. But FINRA definitely is in bed with industry.
Mr. CASTLE. And the NASD you sort of condemned in your previous answer. I assume that hasn’t changed.
Mr. MARKOPOLOS. They are more like RICO. ...
Chairman KANJORSKI. Now if I remember some of your earlier responses to some of the other members, you indicated that you felt that the FINRA you felt was corrupt but the SEC was just incompetent. That is correct?
Mr. MARKOPOLOS. That is correct.
Chairman KANJORSKI. Which is better, to be incompetent or to be corrupt?
Mr. MARKOPOLOS. I would say I would give an A-plus to the SEC for incompetence and I would give the same grade to FINRA for corruption. And fortunately, the SEC was not corrupt as far as I could determine in this case. I think I am living proof of that.
Chairman KANJORSKI. In what way? They saved your life in some way?
Mr. MARKOPOLOS. I am still standing. I don’t think I would have been if they had taken money to look the other way and told Mr. Madoff my identity and, by the way, these are the SEC’s submissions he has been giving us over the years. I don’t think I would be here today.
[Effectiveness of pursuing whistleblower tips.]
Mr. MARKOPOLOS. ... I brought with me the Association of Certified Fraud Examiners 2008 Report to the Nation, and it lists in here that the best way to find fraud; 54 percent of the frauds get discovered by tips, whistleblower tips; only 4 percent by external auditors which—the SEC is an external auditor. Therefore, whistleblower tips are 13 times more effective than external auditing. So why wouldn’t we want the SEC to be 13 times more effective? Lord knows, this Agency needs to be more effective. ...
Mr. ARCURI. ... you make references to the New York Attorney General, to the—I think it was the Massachusetts.
Mr. MARKOPOLOS. Securities Division.
Mr. ARCURI. Securities, thank you. And yet they don’t have that type of people in their office. They have small, lean offices. How do they do it and the SEC is not able to do it?
Mr. MARKOPOLOS. It is easy. They rely on whistleblowers to come in with tips which they vigorously pursue. When the SEC gets a tip, it vigorously ignores it.
[How the SEC does audits, and how they should do them.]
Mr. WILSON. My second question has to do with auditing, which I would think is one of the things the primary would focus when there are wrong things being done. Could it be a random assigned auditor rather than the same old same old that they have every time?
Mr. MARKOPOLOS. I would rotate the teams personally. You want a fresh set of eyes looking at the books and they want a fresh set of trained eyes. Right now those eyes are not trained. They are also not trained in human intelligence gathering. When they come in to inspect a firm, they are led to a conference room. They meet the compliance staff and they are fed controlled pieces of paper. That is what they do. They inspect pieces of paper because they are too untrained to realize what to look for on the financial end. All they are looking for is pieces of paper. If they see the pieces of paper, you are going to get a fine audit report back from the SEC.
What they need to be doing is talking to the portfolio managers, to the traders, to the marketing people, to the client service officers, the information technology people. And they need to be interacting with them and saying, is there any fraud here? Is there anything illegal or unethical happening here? And if you get a ‘‘no’’ answer, say fine, thank you. Is there any fraud anywhere else in any other organization that your firm deals with or that you know about? And then you hand them your business card. And you say if there is, if you ever discover a fraud, please let me know. And hand them the card. I think if you do that, you will increase audit effectiveness.
[I suggest the chilling Christopher Plummer for Madoff.]
Mr. MAFFEI. Okay. Thank you. And I guess my last question is, who do you want to play you in the movie?
Mr. MARKOPOLOS. Well, it had better be someone who is a Red Sox fan. That is all I ask. ...
Chairman KANJORSKI. Do you want somebody with hair?
Mr. MARKOPOLOS. Not necessarily. Michael Chiklis is Greek and from Massachusetts, so I think he would be perfect.
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